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South32 (ASX:S32) Could Easily Take On More Debt

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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies South32 Limited (ASX:S32) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for South32

What Is South32's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 South32 had US$520.0m of debt, an increase on US$366.0m, over one year. But on the other hand it also has US$1.61b in cash, leading to a US$1.09b net cash position.

debt-equity-history-analysis
debt-equity-history-analysis

How Healthy Is South32's Balance Sheet?

The latest balance sheet data shows that South32 had liabilities of US$1.46b due within a year, and liabilities of US$2.83b falling due after that. Offsetting this, it had US$1.61b in cash and US$540.0m in receivables that were due within 12 months. So it has liabilities totalling US$2.14b more than its cash and near-term receivables, combined.

Of course, South32 has a titanic market capitalization of US$13.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, South32 also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, South32 grew its EBIT by 222% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if South32 can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. South32 may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, South32 actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

Although South32's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$1.09b. The cherry on top was that in converted 126% of that EBIT to free cash flow, bringing in US$814m. So we don't think South32's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with South32 , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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